Auditing - Chapter 4

Test 2 - The Audit Risk Model and Inherent Risk Assessment, 6 Oct 2026

Audit risk

Probability that an audit team will express an inappropriate audit opinion when the financial statements are materially misstated

3 types of audit risk

1. Inherent risk

2. Control risk

3. Detection risk

Risk of material misstatement (RMM)

Risk that a material misstatement exists in the financial statements before auditors apply their own procedure (inherent and control risk)

Inherent risk and control risk are combines into …

Risk of material misstatement (RMM)

Inherent risk

The probability that in absence of internal control, material errors or frauds could enter the accounting system used to develop financial statements

Control risk

The probability that the client’s internal control activities will fail to prevent or detect material misstatements provided that such misstatements enter or would have entered the accounting system in the first place

Detection risk

The probable that the auditor’s own procedure will fail to detect material misstatements

External’s auditors’ task of control risk assessment begins with …

Learning about an entity's internal control, that are designed to prevent and detect material misstatements

Substantive procedures

Procedures used to detect material misstatements that may exist

Two categories of substantive procedures

1. Test of details

2. Analytical procedures

Tests of details of transactions and balances

Provide specific evidence directly supporting assertions

Substantive analytical procedures

Study relationships among financial (current and prior, and forecast) and nonfinancial data

Auditors are able to reduce detection risk by …

Completing more and stronger substantive tests

3 components of the Audit Risk Model (ARM)

Audit risk (AR) = Inherent risk (IR) X Control risk (CR) X Detection risk (DR)

Based on the planned level of detection risk, auditors modity the …

Nature, timing, and extent

Nature of an audit

Type of procedure (observation, recalculation, inquiry)

Timing of an audit

When the audit procedures will be completed.

Audit procedures closer to year-end (balance sheet date) will be more effective than interim date, because the chance of material misstatements between is lower

Extent of an audit

Number of tests to be performed.

The greater the number of accounts, the greater the chance of finding errors, lowering the detection risk

High detection risk means …

Auditors could use less effective testing

Low detection risk means …

Auditors need more effective testing

Fraud

Act of knowingly making material misrepresentation if fact with the intent if inducing someone to believe the falsehood and act on it, thus, suffer a loss or damage

(True/False) Fraud risk is part of the Audit Risk Model

False, but it cannot be ignored

Fraud vs Error

Intent

To consider the risk of fraud in every audit engagement, auditors are required by professional standards to …

Hold a brainstorming session

Fraudulent accounting entried always affect …

At least two accounts and two places in financial statements, because of the double-entry bookkeeping system

Dangling credit

Credit that was never recorded to a liability account, resulting in an omission of a liability yhat should have been recorded

Completeness assertion

Two types of fraud

1. Fraudulent financial reporting

2. Misappropriation of assets

Fraudulent financial reporting

Intentional misstatements, including omissions of amounts or disclosures to deceive financial statement users

Fraudulent financial reporting is also referred to as …

Management fraud

Efforts of management to manage earnings to deceive financial statement users by influencing their perception about the entity's performance and profitability

Management fraud or fraudulent financial reporting

Misappropriation of assets

Theft of an entity's assets perpetrated by employees in relatively small or immaterial amounts

Misappropriation of assets is also called …

Employee fraud

Employee fraud usually involves …

Falsification of documents

3 phases of employee fraud

1. the fraudulent act

2. The conversion if funds of property to the fraudster’s use

3. The cover-up

employee fraud can be classified as either

Embezzlement or Larceny

Embezzlement

Misappropriation of funds or property entrusted to the care, custody, or control of employees or nonemployees. Accompanied by false accounting entries and other forms of deception

Larceny

Simple theft

Another name for employee fraud, embezzlement, and larceny

Defalcation

(True/False) Audit teams are concerned with fraud only if it affects the financial statements materially

True

Factors related to the susceptibility of accounts to misstatement or fraud

1. Dollar size of the account

2. Liquidity

3. Volume of transactions

4. Complexity of transactions

5. Subjective estimates

Understanding these elements of client’s business is essential

1. Industry, regulatory, and other external factors

2. Nature of the company and related parties

3. Client computerized processing

4. Related disclosures

5. Company’s objectives and strategies

6. Company’s measurement and analysis of its financial performance

Understanding the client’s business: Nature of the company and related parties

• the company's organizational structure and management personnel

• Sources of funding of operations and investment activities

• The company’s significant investments

• Operating characteristics: size and complexity

• Source of earnings: profitability of key products and services, and key supplier and customer relationships

Horizontal analysis

Comparative analysis of year-to-tear changes in balance sheet and income statement accounts

Vertical analysis

Common size analysis of financial statement amounts as proportion

Two types of noncompliance

1. Direct-effect noncompliance

   produces direct and material effects on financial statements (ex: violations of pension laws)

2. Indirect-effect noncompliance

   violations of laws and regulations that are not directly connected to financial statements (ex: health and safety)

Audit strategy memorandum

Basis for audit plan that lists the audit procedure (scope, timing, and direction) for each relevant assertion related to accounts and disclosure identifies on the audit engagement.

not shared with the client